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Market View

Following a new round of market volatility, triggered by a rise in the 10-year U.S. Treasury yield, to 3%, an actively managed floating-rate strategy may merit a fresh look.

 

In Brief

  • Financial markets experienced renewed volatility after the yield on the 10-year U.S. Treasury note topped 3% on April 24, according to Bloomberg.
  • But it’s worth noting one bond category that has held up well during the recent volatility: bank loans.
  • These floating-rate securities have generated positive returns during the rising-rate environment of the past few years, with less volatility than other fixed-income sectors.
  • It may come as a surprise, however, that a popular, passively managed bank-loan vehicle—the largest ETF in the category—has lagged category benchmarks in terms of absolute and risk-adjusted returns.
  • This is one asset class where the evidence suggests that investors may be better served by an actively managed approach that can choose from a larger universe of available loans, and employs rigorous issuer credit research.

 

Investors had been wondering what might happen to markets when the yield on the 10-year U.S. Treasury note eclipsed 3%. They got their answer on April 24, when the yield on the benchmark security reached 3.0014%, its highest level since December 2013, according to Bloomberg. (The yield subsequently moved down to 2.96%, as of the close of trading April 27.) Yields have more than doubled from the July 2016 low of 1.36%. Reflecting growing concerns about the current move higher in rates, U.S. equities (as represented by the S&P 500® Index) sold off on April 24, before recouping much of their losses in the following two sessions.

In addition to the widely publicized move of the 10-year Treasury yield, other short-term rates also have moved higher. In particular, the yield on the two-year U.S. Treasury note hit 2.49% on April 25, an increase of nearly 60 basis points (bps), year to date, and roughly 200 bps since July 2016.  This move in rates has led to negative returns across many areas of the U.S. fixed-income market, with representative shorter-duration indexes generally outperforming longer-duration benchmarks.

But there has been one area of relative calm amid all the recent volatility: bank loans. We had, this past February, written about the performance of bank loans and their relative stability amid heightened volatility in rates and equities.  This week, as the 10-year Treasury bond broached the 3.0% barrier, we thought it would be a good idea to revisit the topic, taking a fresh look at the recent performance of the asset class.

In the rising-rate environment of the past few years, bank loans have generated solidly positive returns, and have been one of the best performing segments of U.S. fixed income.  Given that they have floating-rate, rather than fixed-rate, coupons, loans offer limited duration exposure, and so can perform well when rising interest rates lead to negative returns for longer-duration, fixed-rate bonds. Chart 1 shows the relative performance of the bank-loan benchmark, the Credit Suisse Leveraged Loan Index (the “loan index”), versus the broad bond-market proxy, the Bloomberg Barclays U.S. Aggregate Bond, since June 30, 2016.

 

Chart 1. Since the Summer of 2016, Bank Loans Have Outperformed Core Bonds
Performance of bank loans versus Bloomberg Barclays U.S. Aggregate Bond Index, for the period June 30, 2016–April 20, 2018

Source: Credit Suisse and Bloomberg Barclays Indices.
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Loan investors also are beginning to benefit from the rise in short-term rates.  The average coupon in the loan index had been stuck in a range of 4.75–5.0% for most of 2016–17, despite the move higher in the U.S. fed funds rate, and the upward adjustment in the three-month London interbank offered rate (Libor), the common reference rate for floating-rate loans.  Many issuers had taken advantage of the market environment to refinance loans at lower spreads, offsetting the rise in Libor. But coupons have been floating upward this year (see Chart 2), with the average coupon in the loan index sitting at 5.55%, as of April 26, 2018, more than 50 basis points higher since the start of the calendar year.

 

Chart 2. Bank Loan Coupons Have Floated Higher in 2018
Average coupon on the Credit Suisse Leveraged Loan Index, weekly data, April 30, 2013–April 26, 2018

Source: Credit Suisse and Bloomberg.

Past performance is not a reliable indicator or guarantee of future results. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.


To sum up, bank loans have been able to generate strong performance in the face of rising rates. And those rising rates increase the prospects for high income going forward, as loan coupons adjust upward.

For those who want to add a bank-loan allocation to their portfolios, then, what might be the best way to access this asset class?  Would it be a passively managed product like an exchange-traded fund (ETF), or an actively managed portfolio? Here, it may be useful to take a look at the historical record.

First, a bit of context is in order. While assets in bank loan ETFs have not reached the scale of those in other fixed-income categories, they have been growing. The biggest ETF in the Morningstar Bank Loan category, the PowerShares Senior Loan Portfolio (the bank-loan ETF), tracks the largest 100 loans in the S&P/LSTA Leveraged Loan Index, so it is fairly concentrated in the largest borrowers in the space. Thus, it is much narrower than broad indexes maintained by Credit Suisse (the loan index referenced earlier) and J.P. Morgan (the J.P. Morgan Leveraged Loan Index), each of which includes more than 1,100 issues.

While it has grown in popularity, the bank-loan ETF has been unable to keep up with the average peer in the group in terms of performance. In fact, that ETF has ranked in the 80th percentile or lower in its category (Morningstar Bank Loan) over the trailing one-, three-, and five-year periods through March 31, 2018, while generating higher volatility than the category average. By contrast, Lord Abbett’s actively managed strategy has delivered higher returns than each of the ETF, the loan index, and the broader Morningstar category—with less volatility. [However, there is no guarantee that this outperformance will continue in the future.]

 

Chart 3. Bank Loans: Risk-Adjusted Returns of Two Different Strategies versus Category Benchmarks
Trailing three years, as of March 31, 2018

Lord Abbett Floating Rate Fund expense ratio: 0.69%.

Source: Morningstar performance and rankings. 1PowerShares Senior Loan Portfolio (BKLN). Source: Morningstar performance and rankings. 1PowerShares Senior Loan Portfolio (BKLN). The PowerShares Senior Loan Portfolio is used as a proxy for the broader category of passively managed bank-loan investment vehicles. References should not be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities

Percentile rankings in Morningstar Bank Loan category (as of March 31, 2018): Lord Abbett Floating Rate Fund: one year, 20% (58/235); three years, 10% (24/206); five years, 8% (17/166); 10 years, 22% (17/94). PowerShares Senior Loan Portfolio rankings: one year, 84% (196/235); three years, 89% (181/206); five years, 88% (143/166); 10 years, not available. Morningstar rankings reflect all share classes within the category and are based on total return and do not reflect the effect of sales charges.
Morningstar Bank Loan category average returns are based on all share classes within the category and include the reinvested dividends and capital gains, if any, and exclude sales charges. The net asset value (NAV) performance above shows the Fund’s average annual total returns of Class F shares. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Past performance is not a reliable indicator or guarantee of future results.

 

We previously explored the characteristics of actively managed versus passively managed bank-loan strategies as part of a broader look at taxable fixed-income categories in our commentary, “Staying Active in Fixed Income” (March 19, 2018), which we recommend for those who desire additional information on the topic. In that piece, we expressed our view of some potential pitfalls for ETFs and other passive approaches: The bank loan index is not easily replicated, and, as a below investment-grade asset class, bank loans merit a greater focus on credit research, something that an active manager is better equipped to handle.  [Note: Employment of active-management techniques and strategies in managing investment portfolios does not guarantee outperformance versus passively managed strategies based on similar asset classes and investment factors.]

It should be noted, though, that over short periods of time, ETFs may be useful for a professional manager who wants to manage cash flows and achieve exposure to the asset class. But taking the longer view, we believe actively managed portfolios have a greater opportunity to deliver more attractive risk-adjusted returns for bank-loan investors.

 

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CONTRIBUTING STRATEGIST

RELATED FUND
The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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